No business can get all the capital it needs by borrowing. The owners provide the business with its start-up and its continuing base of capital, which is generally referred to as equity. Without the foundation of equity capital, a business wouldn’t be able to get credit from its suppliers, and it couldn’t borrow money. As they say in politics, the owners must have some skin in the game.
The equity capital in a business always carries the risk of loss to its owners. So, what do the owners expect and want from taking on this risk? Their expectations include the following:- They expect the business to earn profit on their equity capital in the business, and they expect to share in that profit by receiving cash distributions from profit and from increases in the value of their ownership shares — with no guarantee of either.
- They may expect to directly participate in the management of the business, or they may plan to hire someone else to manage the business. In smaller businesses, an owner may be one of the managers and may sit on the board of directors. In very large businesses, however, an owner is just one of thousands; they elect a representative board of directors to oversee the managers of the business and protect the interests of the non-manager owners.
- Looking down the line to the eventual demise of the business, owners expect to receive a proportionate share of the proceeds if the business is sold or to receive a proportionate share of ownership when another business buys or merges with the business. They may end up with nothing in the event the business goes kaput and there’s nothing left after paying off the creditors of the business.
Looking more closely at owners’ equity, you need to distinguish between two distinct sources. Each source is accounted for separately, which may in fact be required for legal purposes:
- Invested capital: This type of owners’ equity account records the amounts of money that owners have invested in the business, which could have been many years ago. Owners may invest additional capital from time to time, but generally speaking, they can’t be forced to put additional money in a business (unless the business issues assessable ownership shares, which is unusual). Depending on the legal form of the entity and other factors, a business may keep two or more accounts for the invested capital from its owners.
- Retained earnings: The profit earned by a business over the years that has been retained and not distributed to its owners is accumulated in the retained earnings account. If all profit is distributed every year, retained earnings has a zero balance. If none of the annual profits of a business have been distributed, the balance in retained earnings is the cumulative profit earned by the business since it opened its doors (net of any losses along the way). If a business has never made a profit, its accumulated loss causes retained earnings to have a negative balance, which generally is called a deficit.
Whether to retain part or all of annual net income is one of the most important decisions that a business makes; distributions from profit have to be decided at the highest level of a business. A growing business needs additional capital for expanding its assets, and increasing the debt load of the business usually cannot supply all the additional capital. So the business plows back some of its profit for the year instead of giving it out to its owners. In the long run, this may be the best course of action because it provides additional capital for growth.